John Dorfman
Wed, 14 Apr 1999, 12:27am EDT
Meet PEGGY, Another Tool for Your Arsenal: John Dorfman
Meet PEGGY, Another Tool for Your Arsenal: John Dorfman
(John Dorfman is a Boston-based money manager with Dreman
Value Management in Jersey City, New Jersey. The opinions
expressed are his own and don't represent those of Bloomberg LP
or Bloomberg News, or necessarily those of his firm. The firm or
its clients may own or trade investments discussed in this
column.)
Boston, April 13 (Bloomberg) -- I learned about a new stock-
picking tool last week -- new to me, anyway. It's called the PEGY
ratio, although I call it PEGGY, which is more homey and
familiar.
If you want to put your faith in PEGGY, you should consider
stocks such as World Color Press Inc., Revlon Inc. and Milacron
Inc. I'll explain why in a minute. But first, come on in and meet
PEGGY.
PEGGY is a refinement of the PEG ratio, which has come into
fairly widespread use the past five years. The PEG ratio, as some
of you already know, is an attempt to tell whether a stock is
overvalued or undervalued in light of its earnings growth rate.
The initials PEG stand for P/E to growth ratio.
To build a PEG ratio, you start with a stock's P/E, or
price/earnings ratio, a figure found daily in the stock tables of
any major newspaper. The P/E is the stock price divided by per-
share earnings (usually for the previous four quarters). If Cheap
Luxury Corp. sells for $75 a share and has earnings of $5 a
share, its P/E is 15.
To compute a stock's PEG ratio, divide the P/E by the
stock's annual growth rate. If Cheap Luxury's earnings have been
growing at a 7.5 percent annual clip, the PEG is 15 divided by
7.5, or 2.
The lower the PEG figure, the better. Traditionally, a PEG
ratio had to be well below 1.00 to look attractive. In today's
pricey market, a PEG ratio of 1.25 or less looks cheap.
History Shows
I last wrote about the PEG ratio in February 1998. At that
time, I noted that it was the most effective of more than two
dozen stock-picking methods tested by Richard Bernstein, chief
quantitative analyst for Merrill Lynch & Co., over the 11-year
period from 1987 through 1997. During that span, stocks with a
low PEG ratio averaged an 18.6 percent annual price appreciation.
The average annual price gain for the Standard & Poor's 500 Index
over the same period was 13.4 percent.
The point of the PEG is that the traditional P/E ratio
tells you whether a stock is cheap, but not whether it deserves
to be cheap. The PEG in effect tells you how much growth you're
buying for your money.
The refinement that turns PEG into PEGGY is to change the
denominator of the ratio from just the growth rate to the growth
rate plus the dividend yield. After all, part of a stock's annual
return is the dividend it pays. The PEG ratio in its traditional
form doesn't take that dividend yield into account. PEGGY (or
PEGY, for purists) stands for P/E to growth-plus-yield.
To return to our previous example of Cheap Luxury, let's say
the stock has a dividend yield of 2.5 percent, on top of the
previously mentioned 7.5 percent earnings growth rate. In that
case, the PEGGY becomes 15 divided by (7.5+2.5), or 15/10, which
works out to 1.5.
I was introduced to PEGGY through some research prepared by
Morgan Stanley Dean Witter & Co. quantitative analyst David
Lipschutz. In a report dated March 26, he offered a list of 65
''most attractive and lowest-PEGY stocks.''
Lipschutz and Bernstein use projected earnings growth rates
(over the coming five years) in their PEG and PEGY ratios.
Because I distrust analysts' projections (too much straight-line
extrapolation into the future), I prefer ratios based on a
stock's historical earnings growth rate.
Old and New Favorites
Among the stocks on Lipschutz's list are a few I have
mentioned favorably in this space -- Keane Inc., Arrow
Electronics Inc. and Dana Corp. There are also a large number of
stocks I haven't previously looked into but now would like to.
For example, World Color Press, according to Morgan Stanley
Dean Witter, has a P/E ratio of 10.7, an anticipated growth rate
of 16.7 percent, and a PEGGY of 0.64. The Greenwich, Connecticut,
company does printing and related tasks for magazine, book and
other publishers. It has 48 facilities around the U.S. Having
spent the first half of my professional life as a journalist, I
can tell you the company has an excellent reputation for quality
work.
Canadian National Railway Co., based in Montreal, operates
some 64,000 railroad cars carrying grain, wood, coal and other
products on close to 14,000 miles of track in Canada and the U.S.
Morgan Stanley Dean Witter puts its P/E ratio at 7.3 and its
growth rate at 12.4, with a PEGGY of 0.53. (The Bloomberg News
description of the company shows a PEGGY of 0.96, which is
attractive but not as glaringly so. Different databases will
often have varying figures, particularly for the estimated growth
rate.)
A company that particularly surprised me was Revlon, the New
York-based cosmetics giant. Morgan Stanley Dean Witter assigns it
a remarkably low PEGGY of 0.36, based on an 8.8 P/E ratio and a
24.7 percent estimated growth rate. I think analysts are too
optimistic on the growth rate, but I'm intrigued, nevertheless.
Cautionary note: Revlon has posted losses recently, and as of
year-end 1998 it had debt far exceeding stockholders' equity.
Struggling Milacron, a Cincinnati-based maker of such
prosaic products as grinding wheels and industrial magnets, has
rebound potential, in my view. The Lipschutz report gave it a P/E
of 7.2 and a growth rate of 11.9, with a PEGGY of 0.49. I'm old
enough to remember when this was a hot-concept company that would
revolutionize the world with its manufacturing robots. There
aren't many major stocks around selling for less than half their
price in 1981. But if $40.13 was too high 18 years ago, it's just
possible that the current price of $16.56 is too low.
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